Trader’s Narrative

There’s much to cover in this week’s roundup of sentiment data, so let’s dive right in:

Sentiment Surveys
The American Association of Individual Investors’ weekly survey of sentiment doesn’t show much change. About 39% think the market will go higher - that’s 3% points less than last week - while 45% think the market will fall - that’s a 5% point increase from last week. All in all, the AAII survey hasn’t given us a signal definitive signal since August when it blinked red (excessive bullishness) and earlier in March when it blinked green for excessive bearishness.

The Investors Intelligence survey of newsletter editors on the other hand continues to insist that there are about twice as many bulls as bears: 46.7% bullish and 24.4% bearish. We’ve seen a gentle amelioration in the optimism from last month but still, 2:1 is rather extreme.

Since we’re slicing and dicing sentiment through various surveys, why not take a look at what the millionaires are thinking? The Spectrem Millionaire Investor Index and the Affluent Investor Index are the only one of their kind (if I’m wrong, let me know). Few wealthy investors are ready to jump back into the stock market. Right now they are fond of cash and growing fonder of bonds. While still very cautious towards equities, they have started to tip-toe back in. According to Spectrem, 70% believe a drop in unemployment will signal the end of the recession. So it seems the wealthy are not all that different from the unwashed masses - at least when it comes to their portfolio.

Michigan/Reuters Consumer Confidence
US consumer confidence continued to rise reaching 73.5 - much higher than the expected 70.5. This is the highest level of consumer confidence since January 2008 - before the equity and credit markets cascaded down in a devastating decline. The index of future expectations continued to recover as well, rising to 73 - the highest in 2 years.

This month’s Michigan/Reuters survey also provided for a very large jump in the “News Heard Index” which measures the ‘net’ bias of the good news and bad news that consumers hear. According to Credit Suisse’s chief economist, Neal Soss, the News Heard index has a very high correlation with monthly changes in consumer confidence. So maybe the US economy is starting to turn around. But even if it isn’t, if enough people believe it is, it becomes a self-fulfilling prophecy.

Rydex Traders: All In
This week’s weakness in the stock market has been enough to bring out the bargain buyers within the Rydex market timing community. Right now there are twice as many assets in the bullish side as the bearish side. Every time that we’ve seen this extreme in recent times, the market has either paused or corrected. For more information, see Guy’s blog: Technical Take.

Fund Flows Data
If you were reading the blog earlier this week, you caught the chart of equity vs. bond mutual fund flows. While it is still premature to label it a trend, the preliminary data shows that the average US retail investor is not being enticed to re-enter the stock market in the least. Not even by an astounding 57% recovery in the S&P 500. They are in fact withdrawing their money from equities and stuffing it in various bond funds. The anecdotal evidence points to a traumatized populace which has been burned so many times, it has simply decided to withdraw and not play a rigged game.

Other than the implications for stock market sentiment, which are many, this brings up another important point. Whatever the impetus for this rally, the mutual fund data suggests that the US retail investor is not it. So if the masses who were once weaned on “buy and hold” are not buying, and corporate insiders are not buying, who is exactly?

Option Traders
We patiently waited many months as the ISE and CBOE option data fed us mild gruel week after week. Now they are both showing excessive call buying as option traders push their luck that the stock market will continue to rise:

The short term average of the ISEE index (equity only) which measures retail call buying relative to put buying is now at 194. This means that on average almost twice as many calls were bought as puts to initiate a position by retail traders. The last time this indicator was at these lofty levels was in November 2007. The highest it reached during that cycle was 229 on October 15th 2007 just days after the bear market top.

And here is the chart for the 10 day moving average of the CBOE (equity only) put call ratio showing basically the same amount of excessive bullishness:

The confirmation that these two separate option sentiment indicators provides is welcomed, especially after so much time where they either disagreed with one another or didn’t flag any extremes at all. The message right now is crystal clear.

A few days ago we discussed the bearish implications of the S&P 500 being 20% above its 200 day moving average. A similar study from Quantifiable Edges based on the CBOE put call ratio data shows a similar outcome.

Gold Sentiment
Gold is once again flirting with the $1000 level. It has once again lost the four figure handle but from various sentiment indicators, we have good reason to expect this current charge to succeed in breaching the $1000 line for good.

The Hulbert Gold Newsletter Sentiment Index (HGNSI) is showing a surprising lack of excitement this time around in contrast to the other previous runs at $1000. The average exposure recommended by newsletters at previous tops was 62%. However, the HGNSI currently only stands at 39.5% (see article for more details).

The lukewarm HGNSI number dovetails with the other various sentiment indicators which I mentioned recently: Google Trends: Gold Sentiment Neutral and Various Perspectives On Gold At $1000.

Grey Beards
Let’s check in with the ‘grey beards’ - those that have either been prognosticating for a lengthy time or have been extremely prescient to win our admiration and attention. David Rosenberg continues to be unapologetically a non-believer in the current standing of the stock market. He recommends resource sectors, gold, other commodities and the Canadian dollar and Canadian government bonds.

The grumpy bear, Jim Grant has suddenly gone bullish. In a recent Wall Street Journal article Grant outlines his reasons for a more optimistic outlook.

Bob Janjuah of RBS is having none of it - as usual. He is back from vacation with a bah humbug!

All I see is growth and asset price gains driven by the willing and reckless destruction of government and central bank balance sheets.

Magazine Cover
From the contrarian perch, this week’s Business Week magazine cover is a confusing one. Because of the design, there are two covers in one that manages to be both bullish and bearish, depending on which side you hold up and read.

On one side it says: “Why the Market Will Keep Going Up” and on the other it says: “Why the Market is Going Nowhere”. Technically those two statements aren’t polar opposites. Had the negative one said “Why the Market Will Crash (Again)”, that would have been a truly contradictory statement. But then again, the stairs are leading down so maybe I’m over analyzing this. So, will the market go up or down? Yes.

The Evolution of Overconfidence
Finally, here is a fascinating article from MIT’s Technology Review about the evolutionary underpinnings behind the human propensity for overconfidence. Since it is an inherently a self-destructive behavior, how did we manage to survive and why is it part of us in the first place?

By creating a mathematical model of the way overconfident individuals compete against ordinary individuals, they show that there is a clear advantage in overconfidence.

In fact, if the potential reward is at least twice as great as the cost of competing, then overconfidence is the best strategy. In fact, overconfidence is actually advantageous on average, because it boosts ambition, resolve, morale, and persistence. In other words, overconfidence is the best way to maximize benefits over costs when risks are uncertain.

While that may be a neat and tidy explanation, the corollary is disturbing:

Their model implies that optimal overconfidence increases with the magnitude of uncertainty. So the greater the risk, the more overconfident individuals should become. Johnson and Fowler use that finding to predict that overconfidence will be particularly prevalent in domains where the perceived value of a prize sufficiently exceeds the expected costs of competing.

Sound familiar?

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Here is this week’s sentiment round-up:

The AAII weekly sentiment survey shows that the consensus reversed suddenly from the giddily bullish extreme that we saw last week. The bulls fell to 37%, a decline of 17% points. And the bears increased to 40% coming to an almost perfect equilibrium.

While this is a dramatic decrease in their level of optimism, I’m still cautious. The last time we had the same level of bullishness in the AAII survey was in early May 2008. And as I mentioned during last week’s sentiment overview, the stock market didn’t roll over immediately in response. The S&P 500 actually climbed slightly higher in the following weeks. So just because the market has overtaken last week’s highs does not absolve it from a potentially mortal weakness.

The average exposure recommended by stock newsletter editors (as measured by the Hulbert Stock Newsletter Sentiment Index) fell to 30.3% - that’s a sharp decline of 17% points from just 7 days ago. From a contrarian point of view, if the level of bearishness continues to rise even as the stock market rises, then it would imply that this rally still has some life left in it. But we aren’t there yet.

This week’s Investors Intelligence survey was little changed from last week: the bulls were at 48.3% and the bears at 23.1%. This is the only sentiment survey that is dancing to its own tune.

According to the AAII asset allocation survey equity allocation has reached 57% - a level last seen before the equity markets started their cascade down last year.

We touched briefly on the bond allocation at the beginning of the month. At 25% (a 9% point jump!) it is not only the single largest increase but also brings bonds to the highest chunk of the AAII portfolio it has ever been since 1987 when they started keeping track.

Finally, to round off, retail investors are finally feeling comfortable enough to leave the safety of cash. After the cash portion of their model portfolio reached a peak of 45% earlier this year, it is now down to just 25%. As I’ve mentioned before, there is a massive pile of cash sitting on the sidelines and it is slowly being deployed. Of course not all of it is ending up in the equity market, but considering the size of the build-up, even a small portion can have a significant effect.

The NDR Crowd Sentiment Poll is a proprietary sentiment measure from Ned Davis Research. It surpassed its extreme level (61.5) last week. Since then however it has backed off from this threshold and is now 4.3 points lower to 59.1 - this is similar to the other sentiment surveys covered above.

Fund Manager Survey
According to a Merrill Lynch survey of 204 fund managers, managing a total of $554 billion, 75% believe that the global economy will improve in the next 12 months. That is the highest level of optimism since November 2003. A smaller amount (70%) expect corporate profits to rise in the coming year.

Fund managers are putting money where their mouth. They have reduced their cash levels from an average of 4.7% in July to 3.5% in August - the lowest level since July 2007. They have also increased their allocation to equities sharply from last month. Merrill Lynch’s Risk and Liquidity Indicator, which measures risk appetites is at a 2 year high.

This dovetails nicely with what we are seeing from the AAII model portfolio allocation (above). The build up of cash was a sudden, fear induced spike. But the unwinding of it is more orderly as a gradual stream of investors decide that it is safe to venture out once more and take risks again.

Option Traders
The CBOE (equity only) put call ratio continues to fall as optimistic traders prefer calls to puts. Friday it closed at 0.51 meaning that traders were trading twice as many calls as puts. The simple 20 day average of this ratio is now at 0.587 - the lowest since June 2007:

Perhaps more importantly, the short term moving average has as a result, broken well below the multi-year rising channel that contained the put call ratio (red arrow).

The lesser known ISE sentiment index (equity only) reached a high of 202 on Friday. Being a call put ratio, this means that for every 100 puts, there were 202 calls being bought. But the short term moving average of this indicator is still treading water and not at an extreme.

Magazine Cover Indicator
Here is the August cover for Futures - a magazine dedicated to news and analysis of options, futures and stock trading. It is not a general interest magazine like Newsweek or even Business Week so I’m not sure how much contrarian weight we can put on it.

In any case, the image is of a hazy outline of a bull appearing in the distance. The implied question is, “It might be, it could be, is it?” meaning a bull market. Obviously this is the question that many are grappling with.

The interesting aspect of this cover is that it is not boldly trumpeting the arrival of a new bull market but instead timidly asking if it might be, could be true. And finally, wondering if it truly is.

By the way, if you have a US mailing address, for a limited time you can get a free subscription to Futures Magazine. I’m not sure how long this special offer will last so sign up right now.

Consumer Confidence
The preliminary Consumer Confidence survey from Reuters/University of Michigan showed a surprising decline to 63.2 for August - back to a level not seen since March 2009 when the market hit its trough. It would seem that the US consumer is being buffeted with the cross winds of deflation, which make things more affordable, rising unemployment and a schizophrenic stock market. No wonder then that they can’t seem to make up their mind:

Below is this past week’s summary of sentiment data:

AAII
According to the American Association of Individual Investors, the average retail investor in the US is down right giddy. This week the bears declined by 2% points to number just 33%. The bulls meanwhile managed to eke out a tiny 1% point increase from last week to reach 51%. Anytime we see the magical 50% mark in either camp, I take special notice.

To find a higher level of bullishness, we have to go back to May 2008. For the week of early May 2008, the AAII survey showed 53% bullishness. In that sentiment overview, I wrote:

There is no way we can discount or ignore this. Such a high level of bullishness is downright frightening - from a contrarian point of view.

When I wrote the above, the S&P 500 was trading around 1410. In a few weeks it had managed to peek over 1420. But that was it. If you were looking or a sign that the market rally had petered out, you would have a hard time finding a better one. By July 2008 it had fallen to 1200 and by November to 750. As well, this level of bullishness is extra noteworthy because it was at this level of optimism on October 2007 that the stock market topped and entered into its current bear market.

In the same way, I think today, if this single data point doesn’t make you run for the door, it should at least be making you eye the exits warily. While the retail investor has been building back their confidence throughout this rally, their increasing bullishness will inevitably reach a climax point. Here’s a chart showing the last 3 times that the AAII sentiment was so optimistically lopsided that at least 50% were bullish:

Continue reading ‘Sentiment Overview: Week Of August 14th, 2009′

Here is the sentiment summary for this shortened holiday week (Happy belated Canada day and 4th of July!):

Investors Intelligence
Stock newsletter editors were on average unchanged from last week: bulls 41.4% and bears 29.9%.

AAII
The weekly retail investor sentiment survey from AAII shows a sudden jump in optimism: the bulls came in at 38% - a 10% point jump from last week. While the bears are 45% of respondents, a drop of 4% points from last week.

It is difficult to parse the meaning of this move back and forth. First much more bearish, now decidedly less so. Since we didn’t really reach any levels of historical significance with this sentiment indicator, the only thing we can safely say is that retail investors are skittish but not despondent.

Barron’s Confidence Index
This is among Richard Russell’s favorite indicators. The Barron’s Confidence Index is a ratio between Barron’s high-grade corporate bond index and Barron’s intermediate-grade corporate bond index. So basically it shows how much or how little demand there is in the more speculative, lower grade bond market.

The lower the Confidence Index, the less inclined people are to accept risk in the bond market and the higher, the more they are willing to take on risk. Historically 60 has been considered an extremely low level. But as you can see, we easily sliced through that level during last year’s credit market turmoil:

Source: Plexus Asset Management

But since the low late last year, the credit market has improved and we are now trying to return to normalcy. There is a high correlation between this indicator and the equity markets, which is why Russell follows it so keenly. It can be considered a good proxy not only for the bond sentiment but for the over all appetite for risk. There are many indications which confirm this point of view, for example the return to earth of the TED spread.

You can follow the indicator by rifling through the pages of Barron’s print edition or you can alternatively find it online.

Magazine Cover Indicator
This week’s magazine cover sentiment comes courtesy of Business Week, purveyor of many fine contrarian cover indicators in the past. This week’s cover asks:

Can You Afford to Retire?
After watching their savings evaporate and their net worth plunge, many are giving up on retirement planning.

The graphics is a clever play on the falling stock market, in a thick red line… which transforms into a beach lounge chair.

On the whole it isn’t ’slash your wrists’ or ‘Death of Equities’ gloomy but you have to wonder if this kind of cover would have even been contemplated in 2007.

Here’s the sentiment summary for this week’s trading:

Sentiment Surveys
According to the sentiment surveys, an alarming number of investors and market timers have returned to the long side. The weekly AAII retail investor sentiment survey shows 48% bulls (an increase of 8% points) and 37% bears (a decrease of 12% points). We haven’t seen this many bulls in the AAII survey since the first week of the year. As I’m sure you’ll recall, that was not a happy time for putting new money to work on the long side.

According to ChartCraft, the weekly Investors Intelligence newsletter sentiment survey shows 42.5% bulls and 25.3% bears. The S&P 500 ended the week 21 points higher (or 2.2%) so the market hasn’t really done anything to deserve such hope or devotion.

Barclays Capital Sentiment Survey
Barclays Capital said that only 17.5% of the 605 respondents to its quarterly sentiment survey believe that ‘risky assets’ have more room to rise. Those taking part in the survey were central banks, asset managers and hedge funds. The majority believe that the world economy will experience either a protracted slowdown or if it is in recovery now, it will falter once more (a “W” shaped recovery). Asked whether the spring rally was just a “bear market rally”, 60% agreed - indicating that there is still a lot of dry powder out there.

NAAIM
Along with most sentiment measures the NAAIM trend survey of managers has recovered since the spring lows. For more information on the metric check out: NAAIM Sentiment Survey.

Market Froth
We’ve seen a lightning fast return of speculative trading to the stock market. You can see it in the volume of ‘garbage’ stocks (trading below $5/share) and in the general willingness of most people to shrug off the dark foreboding sense they harbored just a few months ago that the end was nigh.

There is also mounting evidence from the Rydex fund flows that the trigger happy traders that use these securities to time the market are piling into the long side. This is the case for both leveraged and normal Rydex funds and has in the past marked either significant market tops or the start of a plateau. In either case, when there is so much lopsided optimism in Rydex mutual funds, it is a flashing red light for those long the market.

Magazine Cover
I have a gut feeling that this week’s Economist magazine cover should be framed somewhere for posterity. It is a graphic showing a Tyrannosaurus Rex made up of car parts, leaking oil (as if bleeding).

I can’t help but wonder, if by the time a magazine puts up something like this, have the auto industry sector reached a nadir?

And I’m not thinking that because the image is hyperbole but because it is a creative representation of the unvarnished truth. I’d prefer if it was on Newsweek or Time but we’ll see. I think this Economist cover is one we’ll come back to years from now.